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Options 101, Wednesday, 03/26/2003

Consolidation

by Mark Phillips

HAVING TROUBLE PRINTING?

Following the explosive moves in the broad market over the past couple weeks, a bit of consolidation was to be expected, and that seems to be what we're seeing over the past couple days. War news is still the dominant driver in the market, but that should start to fade a bit as we head into the April earnings cycle. It remains my view that investors looking for good news about economic growth, increased business spending an improvement on the corporate earnings front are being set up for another disappointment.

As we've discussed recently, the market is in the process of correcting its latest extreme oversold reading, and the clearest picture of that shift can be seen in the bullish percent readings, which have all improved dramatically in the past two weeks. The consolidation we're seeing over the past couple days though, is just a part of a much larger consolidation pattern that likely will still take some time to work through. I certainly don't have any special knowledge about how this consolidation will resolve itself, but it will certainly be exciting when the pattern breaks.

We've been talking at great length in recent months about the interesting (and somewhat anomalous) behavior of the VIX. We've been watching that descending trendline connecting the highs from last July and October, noting that the VIX just can't seem to push through that trendline (except for a one-day wonder on March 12th), despite the persistent market volatility. On a micro scale, the most interesting feature of the VIX is displayed on days like today, where the market falls, yet so does the VIX. Put in layman's terms, this behavior seems to indicate that based on action in the options market, fear of the downside is continuing to wane.

While writing my LEAPS commentary over the weekend, I noted that there appears to be another trendline in play on the VIX, which started with the lows last March. Taken together, these two trendlines show a huge consolidation wedge in the VIX, which must resolve itself before the end of May.

Weekly Chart of the CBOE Market Volatility Index (VIX.X)

See how this huge wedge comes to a point by the end of May? One way or the other, the VIX is going to need to break out of this pattern by that time. Will it just crawl past one of those trendlines, or will it be an explosive move? Obviously I don't know the answer, but I'm expecting a big move. The big unknown is which way it will break. As you might guess, my expectation is for a break to the upside, based on my bearish outlook for the broad markets through at least the middle of the year.

One other aspect of the VIX that Linda Piazza and I have been noticing is the extremely high (relative to historical norms) level of the 200-dma of the VIX, which is now at an all-time high of 35.77. Since I used a weekly chart above, I've approximated the 200-dma by using a 40-week moving average, which currently sits at 35.61. A couple months ago, I looked back through the long-term VIX chart and found that at no time have we seen the VIX able to move more than 17% below its 200-dma. Extrapolating that out to the future, with the 200-dma hovering just below 36, I recently postulated that the new "floor" for the VIX is near 29.50. Using a value for the 200-dma of 35.77 and multiplying by 83% (a 17% drop below the 200-dma) gives a value of 29.69. What I find interesting here is that a quick look at that lower trendline shows that the VIX should find support in the 29.00-29.25 area. Not exactly the same number, but if we push that test out to the middle of April, that trendline will be right at the 29.50 level. If nothing else, it certainly bears watching the pattern.

In my mind, the whole picture of consolidation became that much clearer on Monday, when I read Linda's Index Wrap, "Making Predictions". In her response to a readers request for a prediction of where the OEX was headed, Linda drew some interesting trendlines that deviated just slightly from what I had on my charts at the time. You see, I had noticed that Friday's rally had driven the OEX through its long-term (connecting the highs from August 2001 and March 2002) descending trendline and was a bit surprised that it had broken so easily. But Linda pointed out that on long-term charts, it is sometimes more effective to use a log chart. When I changed my scale to 'log' I noticed that the upper trendline I had drawn popped up significantly to about $473. That combined with the trendline from the July lows shows a similar consolidation wedge to what we see on the VIX chart.

Daily Chart of the S&P 100 (OEX.X)

The way I see it, investors think the market has discounted the worst possible scenario for the economy. In fact, they've demonstrated that belief on 3 separate occasions in the past year - July, October and then again on March 12th. This is just the latest recovery from the bottom of what is now becoming a rather mature consolidation pattern. I don't think the worst has been factored in yet, but the real verdict will come from the market, not from my assertions. If my expectations are to be met, then sometime between now and early June, the OEX should break down below its ascending trendline on a closing basis, while at the same time, the VIX explodes through its descending trendline. So how will I know if I'm wrong? I'll have my first indication of that development with an OEX rally through its descending trendline (currently just above $470), which will likely be accompanied by the VIX falling below 29. But for real confirmation of a bullish resolution to this pattern, we'll need to see the OEX rally through the $490 level, which would represent a breakout over both the August and December highs of last year.

There's still a fair amount of time left in this consolidation pattern, but hopefully this analysis can provide another tool for traders to use when trying to evaluate the longer-term direction of the market, planning their trades accordingly.